Is Setser Too Sanguine?

Brad Setser’s, Follow The Money, did its usual good job of putting the current Fed stance in perspective today. He notes that the Fed is has become the middle man for large scale financial transactions:

Banks with spare cash (more deposits than loans) used to lend to banks that were short of cash (more loans than deposits). Now they lend to the Fed, and the Fed lends to the banks that are short on cash. That way no bank risks taking losses lending to a bad bank ….

Money market funds used to lend both to the financial sector and to firms with short-term financing needs. Now they (to simplify a bit) just buy Treasuries. The Treasury met this demand by increasing its issuance, and (to simplify a bit) putting the cash it raised on deposit with the Fed. That in turn allowed the Fed to lend to institutions in the US and abroad that previously relied on money market funds for financing.

Foreign central banks used to buy rather significant sums of Agency bonds, and in the process finance (indirectly) the extension of credit to American households. Now foreign central banks just want Treasuries. The Fed now plans to purchase rather significant quantities of Agencies, in effect making up for the fall off in demand from other central banks.

So far so good, a really good dose of reality. He doesn’t go into how we get out of this sort of dislocation, but that’s a post for another time. What he does suggest is that the critics who suggest that our creditors might not choose to finance this experiment are wrong (Naked Capitalism and Across the Curve who have a different take). His logic is that those creditors, China for example, but not the only one, will choose not to see the dollar depreciate and withhold support for the U.S. He also thinks that increased savings on the part of the American consumer will provide a source of funding for increased borrowing.

This is where I would take exception with his thesis. He may be right about China and other important lenders to this country but his analysis hinges on a strictly economic analysis. Geopolitical considerations might enter in as well and if they do we might not find our lenders so benevolent. As for the American consumers’ ability to save and thus fund the projected expenditures, count me as a skeptic. Most Americans I know are so strapped they pucker up when they have to fill their gas tank, even at today’s prices. They’re in a hole and aren’t digging anymore. All they want to do is start chipping away at their mountain of debt. Saving is for another day.

The prospect of a significant dollar decline shouldn’t be dismissed quite so lightly. This whole episode has been filled with surprises and it might do us a world of good to start anticipating adverse events.

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